How to respond to market volatility

The sharemarket is off to a rocky start for 2008 and there’s plenty to distract those with an eye for excitement. That’s why I’m rededi­cating myself, as The Intelligent Investor’s research director, to ensuring our team of analysts remain focused on three key things that a value investor must do to produce long-term results:

1. Understand business, accounting and economic matters

2. Know how these factors apply to a

given stock

3. Appreciate the impact of investor

psychology on market prices

At any given time, investors seem to place too little weight on at least one of those factors, if not two. The consequence is a distorted view of reality due to the overweighting of one or two factors.

The first point generally receives too much attention. While understanding the “rules of the game” (accounting principles and business funda­mentals, for example) is crucial, too many of soci­ety’s resources are consumed with opinions about the latest snippet of economic data or the monthly movements of the sharemarket or Aussie dollar.

Mostly, it’s hot air. As legendary fund manager and author Peter Lynch wrote: “If you spend more than 13 minutes analysing economic and market forecasts, you’ve wasted 10 minutes.”

It’s captivating to think that by sagely reading the economic winds we might trim our portfolio sails appropriately and catch a huge profit. It’s also dumb. Take a look at our own Reserve Bank’s record on predicting inflation. If 12 months ago it had properly anticipated today’s events, it would not now be scrambling to jack up rates. If the Re­serve Bank, with economists, data and wise board members can’t get it right, what hope for anyone else?

The second point relates to individual stocks. The most common mistake here is placing too much weight on a topical “theme”. Six years ago that might have been terrorism or “geopolitical risk” (remember that?); a year ago it might have been private equity; and today it might be the highly publicised issue of carbon credit trading. That’s not to discount the importance of any of those factors, but it’s crucial to see them in context.

Six years ago, for example, a Woolworths shareholder whose worry list was dictated by the newspaper headlines might have been fretting about terrorist attacks in supermarkets, or supply chain disruptions due to some kind of “geopoliti­cal event”. A year ago the attractiveness of Wool­worths’ prodigious cash flow might have been front of mind. Was Woolworths going to be the next private equity “victim”?

You get the idea. Such issues should be considered, but only within the context of all the other factors impacting the success or failure of the company.

The first two items on the value investor’s list relate to “real” factors, the third to perceptions. The critical point is to arrange your finances so the mar­ket’s short-term whims cannot trigger a harmful financial event—a lesson painfully learned recently by the likes of David Coe at Allco and Eddy Groves at ABC Learning Centres.

At The Intelligent Investor, it’s business as usual despite the market turmoil. If you too have a long-term value bent, my advice is to remain focused on this three-item checklist and keep improving your skills in each area. To do anything else is to flounder.